INVESTORSFRIEND INC. NEWSLETTER - February 14, 2004
Valentines Day
It's valentines Day 2004. I love analyzing companies using the principals of
finance and accounting to find stocks are more likely to reliably make above
average returns. I'd love to help even more people achieve progress on their
financial goals in 2004.
I'm already feeling good about 2004 since my
investments are up 6.7% in this new year already.
Becoming a millionaire requires a low risk rather than a high risk
approach
Most do-it-yourself online investors are recklessly gambling rather than
investing. A visit to the message boards on
www.stockhouse.ca quickly reveals a rabid and frenetic level of posting on
highly speculative stocks. Clearly investors on these message boards are hoping
to make quick gains of hundreds of percent from companies that often have yet to
make a dime. Meanwhile, blue-chip dividend-paying companies that have
consistently delivered steady annual returns of 15% and more are all but
ignored. For example, the most popular stock on these message boards when I
checked today was a company called International Wex Technologies Inc. A quick
check of www.sedar.com reveals that this
company has just $8 million in assets, and $27 million in accumulated losses.
Fortunately it has no debt. The shares trade at $7.60 and there are about 24
million shares. Therefore this company with $8 million in assets is trading at
an incredible $183 million. Clearly this is a very tiny and incredibly
speculative stock. And yet investors are absolutely rabid for it! Maybe it will
turn out to be a big winner but for every Wex Technologies that really makes it
there are many more that crash and burn.
Maybe people think that they need to take high risks to make big
returns. That kind of thinking is a gross misinterpretation of portfolio theory
which indicates that the ONLY kind of risk that theoretically adds to
return is to hold the market portfolio and add risk by leveraging with borrowed
money. And that only works if the markets are efficient and the economy is
competitive. In reality many companies have quasi-monopoly characteristics and
have histories of making high returns at low risk.
The reality is that lower risk strategies can virtually guarantee that
investors can easily amass $1,000,000 or more (in today's dollars) over an
investment lifetime.
For example if you invest $6000 per year at 8% (after inflation) it will grow
to $734,000 in 30 years. At 10% it would grow to $1,085,000. At 12% it would
grow to $1.6 million.
In reality, 10% after inflation may be difficult to achieve but it is not out
of reach by following a low risk strategy of investing in proven successful
profit making companies, particularly those which are trading at bargain prices.
This strategy is almost guaranteed to insure that your wealth will grow over the
long-term. (Though with some volatility in the shorter term) To insure the
strategy works an investor could increase their yearly investment amount. In
contrast a strategy of focusing on the type of highly speculative stocks that
are so popular on message boards has very little certainty of working. You could
get lucky, but relying on luck is a very risky strategy.
Business Income Trusts a Major Investment Phenomenon
Business Income Trusts are truly a major investment phenomenon in Canada.
Investors have made stellar returns in two ways.
First investors have enjoyed the high yields, often in the eight to ten
percent range. On top of this many Trusts have rather unexpectedly delivered
capital gains.
Second, investors in corporations have enjoyed huge capital gains of 25% to
100% or more when a corporation had converted its trading shares into shares of
an Income Trust.
The high returns for Income Trust holders could continue for several reasons.
Many of these Income Trusts have been able to grow by retaining some of the cash
flows for growth. In some cases they have been able to grow by acquiring other
corporations and assets and bringing them into the tax-free Income Trust tent.
However, not every Income trust will grow its distributions. Some of the capital
gains that Trust Investors have enjoyed was due to a decline in interest rates.
That is unlikely to continue and in fact would cause the unit prices to decline
if interest rates rise. Investors therefore have to be selective, but there are
Trusts that will continue to offer very attractive total returns.
The conversion of Canadian corporations into Income Trusts is a phenomena
that is probably going to pick up steam. The Income Trust Structure effectively
eliminates corporate taxation and most companies that are reliably profitable
enough to pay large amounts of income tax can increase their value significantly
simply by converting. Astute investors who own those corporate shares will enjoy
windfall gains as the company converts.
So far, many Income Trusts have been small, in the range of $100 to $500
million, although there have been some larger exceptions. Common wisdom suggests
that very large companies will not convert because they are simply too large for
the Income Trust market to absorb. I predict that 2004 will prove that wisdom
wrong. I expect to see some very large companies convert. The savings in income
tax are very compelling and this will entice some very large companies to
convert.
It's interesting to note that a $10 billion market value share company could
potentially convert itself to an Income Trust that might be worth $15 billion.
This does not mean that $15 billion or even $5 billion has to raised from the
market. In fact not a dime has to be raised. Instead the shares that formerly
traded at a $10 billion value would become Trust units that could trade at $15
billion without 1 cent being raised in the market. The same thing happens when
any company's shares increase by 50% in the market, the new value is in fact
created out of thin air and no new money is needed. Therefore the argument that
the Income Trust market could not support a huge IPO is no barrier to large
companies converting. One issue might be a barrier is that the current shareholders would not
want to hold the new Income Trust shares. That may be true and could limit the
capital gain on conversion to a Trust. But ultimately the savings in income tax
will still make many deals work.
I have not researched a list of candidates that might convert to Income
Trusts (and offer large capital gains to existing investors). However, potential
names that come to mind include BCE (particularly its Bell Canada subsidiary),
portions of TELUS, Shaw Communications, Rogers communications, CNR, Loblaw, and
Canadian Tire. Many of these companies will protest that they are not suitable
as they need the cash to grow, but a number of companies that have already
converted said the same thing. Other possibilities include Molson, MDS inc. and
many more. Effectively any stable cash-generating entity could convert. In some
cases companies will spin-off parts of their business into an Income Trust and
leave other portions in the corporation business structure.
In my view, the only thing that could stop what is becoming an increasing
rush to convert would be changes to tax laws that take away the Income Tax
Advantages of Income Trusts.
For more information, see my article on
Understanding Income Trusts.
Trading Strategies
Investors often behave illogically due to certain aspects of human behavior.
For example many investors who decide not to buy a certain stock at $6
cannot bring themselves to buy that stock later at a higher price even if they
think it is a great investment. It would psychologically hurt an investor to buy
the stock at $10 since that would seem to be tantamount to admitting that not
buying at $6 was a mistake. And investors don't like to have to admit mistakes.
Similarly it can be very hard to sell a stock that starts to decline. Investors
who did not sell at the peak feel like they made a mistake if they sell it later
at a lower price. The lower the price drops the more psychologically painful it
becomes to sell, no matter what the fundamentals of the company are. This
partially explains the phenomena of investors holding stocks all the way down to
zero. Investors also worry mightily that if they sell a stock, it might then
rebound in price, making them look dumb for selling.
To combat such illogical moves, investors can commit to buying and selling
based on some type of valuation system. If your model says sell then you should
sell and then try to ignore what happens to the stock after that. For 2004, my
own plan is have a higher percentage of my money in Strong Buy and Buy-rated
stocks. If I rate a stock a hold, I will try to have the courage to sell that
stock and move into one of my higher picks.
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good in the last 18 months particularly and has now substantially out-performed
the TSX each year for four years. Although stocks are more pricy now, I still
believe that I can continue to identify winners that will beat the TSX and do so
in a conservative fashion, without taking huge risks. (Of course I cannot make
guarantees about performance, but I will be using the same techniques that have
worked for me in the past.)
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to be a profitable valentines day present to yourself and your future wealth.
End
Shawn Allen
President, InvestorsFriend Inc.